Procurement Perspectives: Contract terms may add dead weight to final price


Government contracting departs from the norm, but the factors that influence government suppliers are nevertheless similar.

Although the world of municipal contracting might seem at first blush to stand a very good distance from the world of price theory, in fact price theory plays itself out every day in the world of municipal contracting in ways that are both predictable and almost uniform in consequence.

The relative size of governments allows them a degree of market influence. Thus, governments have a limited ability to dictate contract terms to the market, provided it is understood that in doing so, the effect will be to adjust the cash price that must be paid under the contract.

More generally, the consequence of departing from prevailing market practice and terms is that any such depart will be reflected in a higher contract price. The prevailing market price for goods and services will reflect the normal allocation of risk between supplier and customer, the normal customer’s service needs and delivery expectations.

It seems fairly obvious that when a customer insists on delivery to some remote location, then the price charged by the supplier to that customer must necessarily increase by a corresponding amount, to reflect the higher costs incurred by a supplier in dealing with that customer.

Similarly, any adjustment of risk that departs from the allocation of risk prevailing within the market will also result is a corresponding similar increases in price.

So long as the adjustment to price properly reflects the probability adjusted cost implications of the occurrence of a particular risk, such variation neither improves nor worsens the city’s position.

The city will pay a higher price for the supply that it receives, but its overall (i.e. full-life cost) remains the same because the selling price increases will be balanced by the increase in supplier’s anticipated cost in meeting the risk assigned to it by the municipality’s form of contract.

Problems arise, however, when a city seeks to push the envelope too far. In many cases, the allocation may generate a disproportionate cost increase relative to the benefit that it affords.

For this reason, a number of terms of this sort that have appeared in recent municipal contracts across Ontario actually work against the municipality’s own interest.

Contract terms add dead weight to a customer’s final price whenever the cost of meeting those terms exceeds the benefit derived by shifting risk to the supplier.

There are many different terms that do so. For instance, it is not uncommon for municipalities to stipulate a given level of warranty coverage as one of the terms of a tender.

However, here goods are being supplied, the supplier usually will be a retailer or wholesaler, rather than the manufacturer of the goods concerned.

If the stipulated warranty coverage exceeds what the manufacturer is offering, then the supplier must assume a higher level of risk in dealing with the city than it does in dealing with its other customers.

However, except in unusual cases, a supplier is in no better a position to access the risk of the additional warranty coverage than is the city.

The most likely consequence is that further dead weight cost will be added to the city’s price. Essentially, the supplier, as would the customer if the roles were reversed, must guess as to the risk that it is assuming. Put in such a position few suppliers are prepared to hazard a risk of guessing on the low side.

In general, contract terms that ask the supplier to take a shot in the dark — in terms of assessing the magnitude and probability of risk — invariably result in a disproportionate increase in price. Sure, we see these types of terms that are encountered quite frequently in the construction context, we just need to understand the repercussions of adding them.

 

Stephen Bauld is a government procurement expert and can be reached at swbauld@purchasingci.com.

Some of his columns may contain excerpts from The Municipal Procurement Handbook published by Butterworths.



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